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Indian IT Stocks Update

Indian IT stocks have moved from strong value plays three months back to momentum stocks, banking on consistent upgrades in earnings estimates to sustain prices. One can expect revenue upgrades will consistently accrue over the next 12-months; 1QFY10 results were a good starting point. The Tier 1 plays for the IT recovery story and it is better to stay away from Tier 2 names as revenue recovery is unlikely to materialize; cost rationalization is already played out and reflected in results.

1QFY10 performance—a good starting point.

The Indian IT companies, with only a few exceptions, beat the Street’s (low) expectations on

revenues as well as margins quite comfortably. More importantly, volume/pricing stability seen

across companies also provided comfort on the worst being over. Expectations of sequential

growth from the next quarter appear firmly set in, despite the companies’ commentary tending on the cautious side. In addition, sharp margin expansion seen across companies also cheered the Street.

Cost cutting the big surprise—sustainable for Tier 1 players but not for others 1QFY10 margin performance of the Indian IT companies drove home two important points—(1) the variable cost structure of the IT services business, and (2) the agile response of the Indian IT companies to the volume slowdown in the industry. Rather ironically, in the middle of a challenging phase for the sector, some of the mid-sized companies reported historically high profitability, and most companies generated robust free cash.

Valuations—stocks moving to peak cycle multiples.

Belief in the potential of the Indian IT sector appears to be back, as reflected in the sharp

expansion in multiples post the earnings releases, but the expectations are possibly running ahead of expectations. A 17-18X PE multiple implies 4-5 years of 15% earnings growth followed by a 5-6% growth in perpetuity. While earnings growth at these rates is not improbable, stocks’ already discounting such growth, leaves little room for disappointment on business improvement or execution. Therefore, tier-I companies are better placed given—(1) lower execution risks and (2) better, well-oiled sales and marketing engine to capture incremental growth opportunities.